Options allow an investor to reduce risk and provide an improved chance to profit from stock market investments. But first, it’s necessary to understand the basic principles behind options. It is important to understand how options work before you consider using them.
What new investors need to know about options:
1. An option is an agreement, or contract, between two parties: a buyer and a seller.
2. Exchange traded option contracts are guaranteed by the Options Clearing Corporation (OCC). There has never been a default in the 36-year history of the OCC.
3. There are two types of options: calls and puts.
4. The option buyer pays a premium to the seller.
5. In return for receiving the premium, the seller grants specific rights to the buyer and accepts specific obligations.
6. A call option grants its owner the right to buy a specific item at a specified price (called the strike price) for a limited time.
7. A put option grants its owner the right to sell a specific item at the strike price for a limited time.
a. The specific item is 100 shares of stock. The generic name is the “underlying asset.”
b. The limited time ends on the option expiration date. Equity options expire on the 3rd Friday of the month, after the market closes for trading (technically expiration is the following morning, but the last time you may sell or exercise an option is the 3rd Friday).
8. An option seller may become obligated to honor the conditions of the contract – i.e., sell stock to the call owner or buy stock from the put owner. If the option expires worthless (see #9), then the option seller is relieved of his/her obligations.
9. What can you do with an option?
a. Sell it. You bought it; you can sell it.
b. Exercise it. This is the process by which an option owner does what the contract allows. Thus, a call owner can exercise the option, and buy 100 shares of the specified stock at the strike price per share – as long as the option has not yet expired. A put owner may sell 100 shares at the strike price. In practice, it’s more efficient to sell an option, rather than exercise.
c. Allow it to become worthless. If expiration arrives and the option has neither been sold nor exercised, it expires worthless.
If you are a typical stock market investor, you adopted a buy and hold philosophy and own stocks or mutual funds. If you are a hand-on investor, you do research and carefully select stocks to own. It’s difficult to beat the market, and most professional money managers cannot do it.
Historically, stock market investing has worked out well. But that provides no comfort for those currently invested. The market recently traded at 12-year lows, and even more frightening is the idea that many investors lost half their assets over the past year.
Why did so many people watch their investments shrink in value and do nothing?
That’s a difficult question. Investors tend to be long. They own stocks. They don’t know how to hedge, or reduce the risk of owning, investments. That’s why options are so important. To me, it’s a crime that so few stockbrokers help clients to adopt risk-reducing strategies.
Here are several great reasons why you should take time to learn how options work:
- Hedging – Options allow you to reduce the risk of investing in the stock market. Imagine how investors everywhere would feel if they learned that the giant losses they suffered were unnecessary. By using appropriate strategies, those losses could have been trimmed by 50 to 90%.
- Insurance – You can buy insurance that protects the value of your portfolio – just as you buy insurance to protect the value of your home or car. This insurance is expensive, but there are strategies that allow you to own insurance for little, or no, cost.
- Income – By selling someone else the right to buy your stock at a predetermined price, you are paid a premium that you can consider to be a special dividend.
- Leverage – You never have to trade a share of stock, and invest far less money than stockholders.
- No Need to Always Be Bullish – Options allow you to create positions that prosper when the market moves higher, lower, or trades in a range. Traditional investors only prosper when stocks move higher.
- Limited risk – You can adopt strategies with limited loss, but with high probability of success. The trade off is that profits are also limited. The limited loss nature of so many option strategies is the single factor that makes them so attractive, in my opinion.
- Indexing – If you prefer to trade a diversified portfolio rather than individual stocks, the major indexes (e.g., S&P 500, DJIA, Russell 2000, etc) have options you can trade.
When you trade options, there are four ways in which each trade can be described:
Buy to Open
A. An order to buy a specific option
B. You are initiating a new position, or increasing an existing position
Buy to Close
A. An order to buy a specific option
B. You are buying an option that you previously sold
C. You are reducing or exiting (closing) an existing position
Sell to Open
A. An order to sell a specific option
B. You are writing (selling) an option you do not own
C. You are initiating a new position, or increasing an existing position
Sell to Close
A. An order to sell a specific option
B. You are selling an option you bought earlier
C. You are reducing or exiting an existing position
Some brokers require that you specify into which of the four categories your trade falls. Others don’t ask because it’s a simple matter for their computers to gather the information.
When you trade spread, or combination orders, you are entering an order to trade at least two different options simultaneously. The same rules apply. When you initiate the trade, the appropriate boxes to check are: ‘Buy to open’ for the option you buy and ‘sell to open’ for the option you sell.
Some beginners get stuck when entering an order because they have not yet learned which of these four choices applies to a specific order. The purpose of this post is to be certain that you don’t have to be bothered with this annoying request from your broker.
Most investors are familiar with stocks and know the language associated with equity investing. But the world of options requires an understanding of a few more terms that may not be familiar to the ordinary investor.
First we shall start out with the basics:
1. Call Option is the right to buy 100 shares of stock for a fixed price during a fixed period of time. Note that owning a call option conveys a right to buy the stock but not an obligation. The holder of the option also has the choice to do nothing.
2. Put Option is the right to sell 100 shares of stock for a fixed price during a fixed period of time. . Note that owning a put option conveys a right to sell the stock but not an obligation. The holder of the option also has the choice to do nothing.
3. Strike Price is the fixed price at which one can buy or sell the shares covered by the option.
4. Option Exercise is the action an investor takes by buying the stock at the Strike Price via the call option. Alternatively if the investor held a put option he would exercise the put option by selling the stock at the Strike Price.
5. Expiration Date is the date on which the option expires and is no longer able to be exercised. Expiration Dates for most options are on the Saturday after the third Friday of the Month. Effectively this means that the last day to trade options is the third Friday of the month. There are exceptions to the third Friday rule, for example there are options that expire at the end of the quarter as well as other time frames.
6. 1 IBM March 100 call option: This is the right to buy 100 shares of IBM at the Strike Price of 100 per share anytime between now and the third Friday of March.
7. 1 IBM April 90 put option: This is the right to sell 100 shares of IBM at the Strike Price of 90 anytime between now and the third Friday of April.
8. Dividend treatment. Options do not pay or receive dividends that may occur on the underlying stock. Thus the option investor should be careful to factor this reality into his price decision. Most option calculator software takes dividends into account when evaluating the fair value for an option.
9. Black Sholes model. The Black Scholes model is considered the standard model for valuing options. It was derived by Professors Fisher Black and Myron Scholes – hence the name. Their derivation was based on solving a partial differential equation which describes a dynamic riskless arbitrage. Fortunately one does not have to know calculus to use the Black Scholes model.
Option rookies are often eager to begin trading – too eager. It’s important to get a solid foundation to be certain you understand how options work and how they can help you achieve your goals – before trading.
Here’s a list of my favorite methods. Note: this list contains strategies that are easy to learn and understand. Each is less risky than owning stock. Most involve limited risk. For investors not familiar with options lingo read our beginners options terms and intermediate options terms posts.
1. Covered call writing. Using stock you already own (or buy new shares), you sell someone else a call option that grants the buyer the right to buy your stock at a specified price. That limits profit potential. You collect a cash premium that is yours to keep, no matter what else happens. That cash reduces your cost. Thus, if the stock declines in price, you may incur a loss, but you are better off than if you simply owned the shares.
Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call
2. Cash-secured naked put writing. Sell a put option on a stock you want to own, choosing a strike price that represents the price you are willing to pay for stock. You collect a cash premium in return for accepting an obligation to buy stock by paying the strike price. You may not buy the stock, but if you don’t, you keep the premium as a consolation prize. If you maintain enough cash in your brokerage account to buy the shares (if the put owner exercises the put), then you are considered to be ‘cash-secured.’
Example: Sell one AMZN Jul 50 put; maintain $5,000 in account
3. Collar. A collar is a covered call position, with the addition of a put. The put acts as an insurance policy and limit losses to a minimal (but adjustable) amount. Profits are also limited, but conservative investors find that it’s a good trade-off to limit profits in return for limited losses.
Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call
Buy one IBM Jan 95 put
4. Credit spread. The purchase of one call option, and the sale of another. Or the purchase of one put option, and the sale of another. Both options have the same expiration. It’s called a credit spread because the investor collects cash for the trade. Thus, the higher priced option is sold, and a less expensive, further out of the money option is bought. This strategy has a market bias (call spread is bearish and put spread is bullish) with limited profits and limited losses.
Example: Buy 5 JNJ Jul 60 calls
Sell 5 JNJ Jul 55 calls
or Buy 5 SPY Apr 78 puts
Sell 5 SPY Apr 80 puts
5. Iron condor. A position that consists of one call credit spread and one put credit spread. Again, gains and losses are limited.
Example: Buy 2 SPX May 880 calls
Sell 2 SPX May 860 calls
and Buy 2 SPX May 740 puts
Sell 2 SPX May 760 puts
6. Diagonal (or double diagonal) spread. These are spreads in which the options have different strike prices and different expiration dates.
1. The option bought expires later than the option sold
2. The option bought is further out of the money than the option sold
Example: Buy 7 XOM Nov 80 calls
Sell 7 XOM Oct 75 calls This is a diagonal spread
Or Buy 7 XOM Nov 60 puts
Sell 7 XOM Oct 65 puts This is a diagonal spread
If you own both positions at the same time, it’s a double diagonal spread
Note that buying calls and/or puts is NOT on this list, despite the fact that the majority of rookies begin their option trading careers by adopting that strategy. True, it’s fun to buy an option and treat it as a mini-lottery ticket. But, that’s gambling. The likelihood of consistently making money when buying options is small, and I cannot recommend that strategy.
Options are versatile investment tools that are used to manage the various risks associated with an investment. More conservative investors aim for minimal risk and more aggressive traders are willing to accept more risk in an attempt to earn more profits. Each adopts a different option strategy.
When dealing with options, it’s possible to measure and modify the risk of any stock market investment. You can take steps you deem necessary to offset as little, or as much, of that risk as desired. When calculating various risks, a set of Greek letters, collectively known as ‘the Greeks,’ are used to measure (or quantify) specific risks associated with an investment.
Let’s take a quick look at a few of the more important, and commonly used, Greeks: delta, gamma, theta, and vega. NOTE: Vega is not a Greek letter, but apparently that’s not an issue.
By calculating the delta, gamma, theta and vega of a position, specific risk parameters are measured, and thus, can be adjusted to suit the risk tolerance of the investor. Let’s take a look at the definitions of the individual options Greeks and in a later post we’ll examine how they are used by option traders.
- Delta measures the rate at which the price of an option changes when the underlying asset (stock, ETF or index) moves one point. Delta is not constant.
- Gamma measure the rate at which delta changes as the underlying moves one point.
- Theta measures the amount by which the value of an option decreases as one day passes. Thus, theta is ‘time decay.’
- Vega measures the sensitivity of the option’s price to a change in the implied volatility (IV), and represents the amount by which the option value changes when IV moves higher or lower by one point.